In light of the impressive equities
market rally from 2009 through 2011, some are wondering if perhaps the
economic long wave has bottomed early. I recently received an email asking a
question that is relevant to our discussion. He writes, "Suppose the big
120-year cycle hit a few years early, which for a cycle this long would
certainly be possible. Perhaps the March 2009 low was the deflationary 120-year
cycle low point, and the bull market just carries on for several more years.
Is this possible?"
Before we can answer this, a
discussion of the mechanics of deflation is in order. Deflation can be
defined as a decrease in either the availability or the velocity of money and
is characterized by, among other things, falling "core" prices.
Certainly we've seen this to a degree in the years since we entered the final
years of the 120-year cycle. Yet many commodity prices, including oil and
food prices, haven't shown signs of being under the sway of deflation except
during the credit crash period of 2008.
While some analysts may take this as
a reason for believing that inflation, not deflation, is the economy's bigger
concern, investors would do well to consider a few points. One of them is
that oil and other key commodities are more easily subject to the influence
of monetary manipulation, i.e. "quantitative easing" and the prices
of these commodities can therefore be skewed against the prevailing deflationary
current. Another point to consider is that the influence of the
multi-billion-dollar hedge fund industry, which specializes in both creating
and chasing momentum in futures markets, can create what appears to be
inflation but actually is nothing more than an artificially induced temporary
trend. The events of 2008 showed just how easily that such artificially
inflated commodity prices can be deflated by the forces of Kress cycle
deflation.
Deflation is more than just a
monetary phenomenon, however. Long-term deflation is also determined by
demographic trends. When a nation's population is in decline - either in
terms of actual numbers or on a rate of change basis - its
spending patterns change. Thus long-term deflation is a supply as well as a
demand issue.
The U.S. will see the effects of this
demographic change in the coming years as more and more Baby Boomers retire
and eventually shift the ratio of workers to retirees in favor of the latter.
This major demographic shift has the potential to threaten a number of federal
social programs and possibly even the current U.S. standard of living. The
demographic shift also partly explains the force behind the 120-year
long-term cycle. Since this demographic shift shows no sign of reversing
anytime in the immediate future, we have one reason for assuming the 120-year
cycle has bottomed "early" and turned up anew.
It also helps to understand that
within the 120-year cycle of inflation/deflation, there are two 60-year
cycles. The current 60-year cycle began in 1954 and will bottom next in 2004.
The final 10% of a cycle's duration is the "hard down" or hyper
deflationary phase. This means the period between 2008 and 2014 is the hyper
deflationary phase of the current 60-year cycle. Hyper deflation, also known
as "winter" season in the terminology of the Kondratieff Wave,
began in 2008 with the onset of the debt crisis. The deflationary winter
season has been somewhat mitigated by the monetary stimulus of 2009-2011 as
well as the peaking of the 6-year cycle scheduled for later this year. The
onset of the final three years of the deflationary cycle in 2012, 2013 and
2014 will bring the worst part of the deflationary "winter" phase
to the U.S. and likely also the global financial market.
As we've already seen, the onset of
"winter" began with the debt crisis of 2008. That crisis wasn't
actually resolved but merely postponed. Had the debt/credit crisis of
2007-2008 been allowed to run its course without government and central bank
intervention, it's very likely that the 120-year cycle of inflation/deflation
would have been fulfilled at least from a financial market standpoint and we
therefore would have seen an early bottom (for all intents and purposes) of
the 120-year cycle. This wasn't the case, however, and instead of allowing debt
to unwind the government actually increased the nation's debt load. Here we
have the biggest argument against an early bottom to the 120-year cycle.
Until we see a significant trend established in the way of debt retirement,
both on the public and a private level, we have no firm basis for assuming an
early bottom of the 120-year cycle.
The following chart found in the July
1 issue of The Long Wave Dynamics Letter is worth a thousand words. It
shows the gross domestic product of the U.S. contrasted against federal debt
levels going back to 1940. As you can see, federal debt (red line) has
actually exceeded real GDP (blue line) in the last couple of years since the
credit crisis began. This is not how the debt-to-GDP ratio should look if we
were in a new 120-year up cycle. If anything this chart strongly suggests the
120-year cycle hasn't bottomed yet, nor has it inflicted its worst damage.
The 2008 credit crisis was likely only the proverbial "shot across the
bow" warning of even worse things to come before the cycle bottoms in
late 2014.
As David Knox Barer, editor of the
LWD Letter put it, "The deleveraging of the U.S. and the world will be
economically painful. A modern day Jubilee of debt reduction and cancellation
through bankruptcy" will tell us the 120-year cycle is nearing its
completion. We haven't seen this yet....
Consider also Washington's latest
response to the contentious issue of the federal debt ceiling. Instead of
moving toward a sensible policy of diminished debt through spending cuts,
policymakers are instead arguing in favor of raising the debt ceiling so as
to add even more debt. The A.P. reported the following on Friday, "The
President cited the gloomy jobs report as one more reason lawmakers must
strike a deal soon to raise the U.S. debt limit, saying the impasse was
fueling uncertainty within financial markets and in the business
sector." Much could be said in the way of analyzing his statement,
particularly the homage that all recent presidents have paid to Wall Street.
Suffice it to say the U.S. has a ways to go before the 120-year cycle has
completed its course.
The Fed's monetary stimulus efforts
of the last two years have done nothing to help what is arguably the biggest
symptom of long-term deflation, namely the housing market. It's important to
recall that the winter season of the deflationary cycle began with a collapse
of real estate prices. The real estate bear market has been the chief
evidence of deflation in the U.S. for the housing market prior to the crash
represented the biggest form of savings for most Americans. Real estate is an
excellent asset to own during the inflationary phase of the long-term cycle
of inflation/deflation but it's one of the worst assets to own during hyper
deflation. As an illiquid asset, housing prices tend to depreciate in the
final years of the deflationary winter season, as many have discovered. Here
is yet another proof that the deflationary cycle hasn't yet bottomed; until
real estate bottoms we can only assume the 120-year cycle still hasn't
bottomed.
The 120-year long wave cycle of
inflation/deflation is driven by many factors, only some of which we can
comprehend. (There is arguably something of a cosmological element in this
cycle which is beyond our understanding, but that I leave for the abstract
theorists to explain). Important for our discussion is that the 120-year
cycle, in its deflationary aspects, is driven by demographic trends, which in
turn influences basic economic demand. The life cycle of a large nation such
as the U.S. is characterized by vigorous growth in the first half of the
cycle; this in turn is inflationary since both production and spending are in
the peak years. When the population begins to age at some point during the
long-term cycle it is accompanied by diminished spending and lower domestic
productivity. This explains America's move from a primarily industrial nation
to a service economy, and finally, to its current status as a predominantly
financial economy.
A vigorously expanding population
also tends to contract large amounts of debt during its prime earning years.
Then, as the nation heads toward retirement, it tends to collectively expunge
this debt. One of the biggest indicators for proving the existence of long-term
deflation is the chart showing consumer installment credit. As you can see
here, the trend has been toward declining debt among U.S. consumers over the
last several years. Notice, too, that the peak in consumer credit outstanding
coincided exactly with the peak of the 60-year cycle in late 1984.
The U.S. government, unfortunately,
hasn't yet learned its lesson regarding the contraction of debt - a lesson
which the average taxpaying American has already learned. Until it does we
can only assume the 120-year cycle must complete its vicious work of debt
reduction before we bid it adieu.
Gold
Many investors have asked, "If
deflation is the main problem facing the economy, why should I own
gold?" Gold, they reason, is an inflationary hedge and if that be so,
how can it possibly benefit from deflation?
Gold is more than an inflationary
hedge, however. As Samuel Kress has shown in his cycle work, gold benefits
from both extremes of the 60-year cycle, namely hyper
inflation and hyper deflation. During the inflationary period of the
current 60-year cycle in the 1970s, gold benefited from the extreme inflation
as the cycle was peaking. In more recent times gold has benefited from
deflation while the cycle is declining. Consequently, investors look to the
precious metal for financial safety in times of uncertainty.
Gold has in fact become the new
long-term investment vehicle of choice for retail investors. Traditional
forms of savings such as real estate have become depreciating assets and no
longer offer protection against the ravages of the long-term cycle. Meanwhile
savers are punished with extremely low interest rates while the value of the
currency diminishes through central bank money printing schemes. It's no
wonder then that investors are turning to the yellow metal as the safe haven
du jour during the "winter" season of the 60-year/120-year cycle.
Economic Outlook
We've been discussing matters
pertaining to the longer-term economic outlook. The short-term outlook is a
different story, however. The residual momentum which has built up courtesy
of the Fed's "quantitative easing" (QE2) program coupled with the
peaking 6-year cycle is still an important variable.
Speculation abounds as to whether or
not the U.S. economy will show any additional signs of recovery this summer.
Opinion seems to be titled in favor of the bearish outlook on the economy for
the balance of 2011. An example of this is found on a recent front cover of Time
magazine ("What Recovery?)
If anything, this magazine cover may
have some short-term contrarian significance and it's possible we could even
see a mini-economic upturn in the coming months and into the 6-year cycle
peak window this fall. But how can we know whether any economic improvement
is forthcoming? The closest thing I've been able to find that provides a
reliable leading signal on the near term direction of the retail economy is
the New Economy Index, or NEI for short. This index is simply an average of
the weekly closing stock prices of five of the most economically sensitive
stocks that also represent the main segments of the retail economy. The
components are: Wal-Mart, Fed-Ex, Monster Worldwide, Ebay
and Amazon.
I've kept the NEI since 2007 and have
been pleased with its performance for the most part. It has often provided a
"heads up" on a significant change in the intermediate-term (6-9
month) trend in the retail economy; at its worst it is a coincident economic
indicator but far ahead of the various economic indices published by the
government in terms of showing real-time changes in the economic trend.
Here's what the NEI looks like as of Friday, July 8, when it was last
updated.
The rules for interpreting the NEI
are simple. As long as the index is in an upward trend the U.S. economy
should be considered to be on a fairly sound footing in the
short-to-intermediate term. Only when a reversal is signaled should we be
concerned that the retail economy will weaken. A reversal occurs either when
the NEI breaks below its nearest pivotal low or when the 12-week moving
average (black line) crosses under the 20-week moving average (red line).
Neither of these things have happened yet; indeed,
the moving averages have recently turned up with the index itself making new
multi-year highs as of July 8.
As long as the intermediate-term
uptrend for the NEI remains intact there's no need to worry about the economy's
prospects in the weeks and months ahead. The economy looks to have obtained a
reprieve of sorts, at least for a while longer. Only if a reversal is
signaled in the NEI will we join the mainstream media in worrying about the
near term economic outlook.
Clif Droke
Editor, The Daily Durban Deep/XAU Report
Clifdroke.com
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